Be careful what you wish for

Why winning its antitrust battle might destroy Microsoft.

JUST BEFORE MIDNIGHT on the eve of opening arguments in US v. Microsoft, company president Steve Ballmer e-mailed Microsoft staff to rally morale and outline the basic principles of their defense. "When you go home to your families, when you talk to your friends at the kids' soccer games or when you talk to business colleagues, remember how much people admire and respect our company," he wrote. "Microsoft's business practices . . . [are] entirely consistent with the way other companies throughout our industry compete. . . . There is no industry in America today that is more innovative and more competitive than ours."

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Outside Microsoft, although the company surely has its fans, you have to hunt far and wide to find people who believe that it does not possess some kind of monopoly. But from where Microsoft sits, things don't look that way: Microsoft has no monopoly because, as company spokesman Greg Shaw puts it, the very idea of a software monopoly is "a questionable concept. . . . It's hard to even imagine a monopoly in software."

Microsoft's defense against the antitrust charges brought by the US Department of Justice relies on the proposition that the software industry is competitive in the most absolute and technical sense of the word. As a result, even some of Microsoft's fiercest critics concede that it enjoys unprecedented exemption from basic antitrust restrictions because online market conditions make a traditional monopoly impossible to attain.

"Hopefully this won't sound like a metaphysical debate," begins Charles "Rick" Rule, who served as assistant attorney general in charge of the Justice Department's antitrust division under Presidents Reagan and Bush and now is counsel for Microsoft. First, Rule concedes that it is nearly impossible, or at least very difficult, to buy a PC without Microsoft Windows pre-installed. He also concedes that Microsoft intentionally undercut Netscape by giving away its Internet Explorer browser for free. It's a textbook example of predatory pricing, he agrees—if your textbook was written before the Internet.

There is currently no statutory definition for predatory pricing. In 1993, however, the Supreme Court applied a standard test developed by professors Philip Areeda and Donald Turner in Brooke Group v. Brown & Williamson, a case involving cut-rate generic cigarettes. According to Areeda-Turner, competition in any industry will naturally drive prices toward marginal costs (i.e., the cost of material and labor in making the last widget, excluding the start-up cost of building a widget factory). Pricing below marginal cost serves no purpose except to drive out competitors, and is therefore predatory. Once competitors are driven out of business, a predatory monopolist can recoup its losses by charging supracompetitive prices, to the eventual detriment of consumers.

Microsoft admits that it gives away Internet Explorer to cut into Netscape's market share and profit. (Netscape had charged up to $59 for its Navigator browser.) "But there's virtually no marginal cost in software," Rule points out. Making an extra copy of Internet Explorer costs practically nothing, and the Internet allows for free distribution. "What happened with Netscape was that Netscape initially gave away its software until it had a 70 percent to 80 percent market share, and raised its price," Rule explains. "Then Microsoft came along, providing competition, and drove the price to marginal costs—zero."

BY THIS REASONING, Rule argues that it's virtually impossible to price software below marginal cost—and therefore, according to established definitions, predatory pricing is essentially impossible in the software business.

"I think Areeda-Turner is terrifically important," says New York University economics professor Lawrence J. White, who was chief economist for the Justice Department's antitrust division just before Rule took over and who remains a harsh critic of Microsoft. "But it does create a dilemma for something like software. I rarely agree with Rick, but [predatory pricing] is not a useful way of thinking about this."

This is most likely why the DOJ is not relying on predatory-pricing charges in US v. Microsoft; instead, it is trying a more nuanced case of illegal bundling—the tying of an inferior product to a monopoly product in order to drive out a competitor in the inferior product's market. However, if you accept the argument that predatory pricing rules don't really apply to Microsoft, then the same circumstances responsible for that exemption—free distribution and zero marginal costs—also support the rather fantastic conclusion that monopoly power can't really exist in the operating-system marketplace, either. And since only monopolies are prohibited from bundling, it follows that Microsoft, not being a monopolist, is allowed to tie one product to another in an "anticompetitive" way.

"It's dangerous to say never," says Rule, "but I don't think the notion of monopoly has a whole lot of weight in the current environment. Sure, most people look at the computer industry and say, 'Oh, gee, Microsoft accounts for a very large amount of operating systems shipped on PCs today,' but monopoly power is not defined by market share." Indeed, in antitrust law, monopoly power is defined as having the unfettered ability to set prices in a given market. Rule argues that no matter how small a competitor's market share, no matter how strenuously computer manufacturers testify that they have no practical alternative to the "monopolist's" product, the industry's negligible distribution costs and marginal expenses enable competitors almost instantly to supply the entire operating-system market in the event that Microsoft raised prices too much. "Ergo, Microsoft doesn't have monopoly power to set prices," he concludes.

TO PROVE ITS POINT, Microsoft's defense briefs (and now the conveniently leaked "Halloween memos" as well) repeatedly point to the Linux operating system, developed by a single programmer, as proof of how cheap it can be to develop and distribute a fully functional operating system. (Don't forget, in this connection, that QDOS, which cost Bill Gates only $50,000 in 1981, became the vehicle with which Microsoft drove then-monopolist Apple Computer to the fringes of the market.) Competition, even potential competition, Rule argues, abounds, and restrains software prices across the board.

This sort of talk makes Professor White apoplectic: "If you believe that, there's a bridge I can get you a reasonable price on. Everybody says it's easy to enter their market. It's bullshit." (Among the more fanciful versions of this argument was the Coca-Cola claim that neighborhood lemonade stands proved that barriers to entry in the soft-drink business were low.) White says that Microsoft's dominance doesn't come from its professed low prices or superior functionality, but from the intrinsic market inclination toward software compatibility.

For example, demand for the first fax machine couldn't have been very high, White says, but a network of fax machines exponentially upped the value of each individual unit. We don't buy Windows because we like it, this theory goes, we buy Windows because everybody else has Windows. Developers build Windows applications because Windows has such a large installed base, and new computer buyers want a full array of applications—so they buy Windows. Actual barriers to entry are therefore very high—maybe impossibly high—in the operating system market once the standard is in place. Ergo, Microsoft is a monopoly.

The apparent silliness of Microsoft's argument may prove less a problem to the company than the consequences of winning its antitrust battle with the DOJ. "This is one proposition that anyone with a computer can evaluate as well as anyone else," says Kevin Arquit, former director of the bureau of competition for the Federal Trade Commission and current attorney for Sun Microsystems. "Frankly, I understand why Microsoft's saying it's not a monopoly. But by taking that point of view, it hurts their credibility across the board. They're just inviting some kind of change."

Such a "change," some observers suggest, could take the form of revisions in antitrust rules. If the rules can't constrain such an obvious monopolist, then the rules have to be rewritten. "Attempts to apply conventional rules don't get you very far," explains University of California­Berkeley economics professor Joseph Farrell, who testified at Orrin Hatch's Senate Judiciary Committee hearings on software competition in November 1997. "I think there are legitimate questions . . . for antitrust agencies to create some new guidelines or for Congress to possibly step in." A committee staffer who asked for anonymity says that he didn't believe Microsoft's claim of exceptional status outside of conventional antitrust law stood "a snowball's shot in hell"—but if the courts rule in favor of Microsoft's claim, "then, yeah, we might look into something."

For his part, Judiciary Committee chair Hatch is not likely to let Microsoft off as easily as the courts might. He believes the century-old Sherman Act is flexible enough to rein in the company, and recently explained to a receptive audience at a Washington conference that if the courts buy Microsoft's arguments, "in effect giving Microsoft a free pass to monopolize Internet-related technologies, [it] would have policy consequences of tremendous proportion, and would ultimately lead to some form of government regulation." Whether [Microsoft's] pattern of conduct, if unchecked, will have serious long-term consequences for competition and innovation in our digital economy, strikes me as an almost rhetorical question." *